Impact of heat price regulation on the optimal district heating production mix and its policy implications

Abstract

The use of district heating systems consisting of a combined heat and power (CHP) and a heat only boiler (HOB) is on the rise in South Korea. In this context, monopolistic district heating providers optimise cogeneration capacity composition to maximise their profits under price regulation. Building upon Joskow and Jones (1983), this study develops a theoretical framework to investigate the role of price regulation on the optimal capacity composition of a district heating system for a regional monopolist. Assuming varying heat demand, wherein the maximum heat load may exceed CHP capacity, the effects of price-cap and rate of return regulations on the optimal mix of the district heating system are examined and compared. The results show that the heat production mix is optimal for price-cap regulation. In contrast, the rate of return regulation hinders the monopolist's incentive to reduce costs. Finally, in case of internalising the environmental benefits of cogeneration, the optimal CHP size in the heat production mix should be increased; consequently, the energy efficiency for producing heat and electricity is likely to improve. This study, therefore, has far-reaching implications for policymakers and practitioners alike in terms of addressing the dual goals of energy efficiency and economic efficiency.